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Is That Sub-$5 Stock Going to Make You Rich?

Can buying stocks with low price tags be the key to huge stock market profits?

At the end of the day, we're all investing to make money, plain and simple. So it's not that surprising that people look for the best ways to make more money and do it faster. Unfortunately, sometimes the ideas about how to make that happen are just plain silly.

Here's a little tidbit from an article I happened on the other day that was talking about stocks selling for less than $5 per share:

Part of the magic is simple logic: A company whose stock is selling for $2.50 has a far simpler task in growing that price -- and the profit behind that price -- than a megalith selling for a couple hundred dollars a share. The cheaper stock can make a little growth go a long way.

Too bad "simple logic" left the building before this statement found its way to (digital) paper.

To be sure, in some cases the idea above appears to be true. China Nepstar's (NYSE: NPD) stock sells for $3.65. It's a growing drugstore chain in China whose small size gives it more growth potential than a huge U.S. comparable like CVS. Berkshire Hathaway's "A" shares, meanwhile, sell for $128,103 each. Berkshire is a massive conglomerate that pulled in $13 billion in profit in 2010. Soaring growth is not in Berkshire's future.

But as the stocks below show, the price tag on a stock often belies the size of the company.

Company

Stock Price

Total Market Capitalization

Citigroup(NYSE: C)

$4.45

$130 billion

Sprint Nextel(NYSE: S)

$4.56

$13.6 billion

Sirius XM Radio(Nasdaq: SIRI)

$1.72

$6.8 billion

Biglari Holdings(NYSE: BH)

$409.41

$587 million

ATRION

$172.32

$347 million

National Presto Industries(NYSE: NPK)

$112.39

$771 million

Source: Yahoo! Finance.

Investing and pizzaImagine you've got a big, piping hot pizza in front of you and you're going to split it 50/50 with a friend. You can cut that pizza right down the middle and each one of you will get your half via one massive slice. Or you could cut it twice and each of you will get two slices -- but still just half of the pie. Or you could go nuts and slice it 16 times, giving each of you 16 very skinny pieces.

But each of you still only gets half of the pie.

It works the same way with a company and its stock. A given company can slice itself into as many pieces as it likes by splitting shares or issuing new shares. But as the total number of shares of a company expands, each share represents less and less of the company's profit and so investors will value the shares at a lower price.

By way of example, if a teeny-tiny company earns $1,000 profit per year, has one share outstanding, and investors give the stock a price-to-earnings ratio of 12, they'd be willing to pay $12,000 for that one share -- and, by extension, the whole company. But let's say the company goes split crazy and ends up with 4,096 shares. Now each share's cut of the profit is only $0.24, and, if investors value the stock the same way, each share would sell for $2.93. Same company, same profit, same total company value ($2.93 multiplied by 4,096 is $12,000), but just a different number of total shares.

The problem with low share priceThere's no magic to a low share price and, in fact, a lot of the time a low share price can simply signal that the company in question was a much mightier company that has fallen on hard times. Unfortunately, the article that contained the "simple logic" above illustrated this through its "5 best stocks under $5."

The list consisted of Pacific Sunwear, Sirius XM, Crown Media Holdings(Nasdaq: CRWN), TranSwitch, and Cowen Group. It'd be a monumental stretch to call any of these small, exciting up-and-comers. Only Sirius and Crown Media have shown any profit over the past year, and even in those cases it's been very modest.

Furthermore, every one of these stocks had a price tag above -- and in most cases well above -- $5 within the past five years, but the prices have been continuously beaten down as investors have become increasingly despondent about lackluster financial performance.

That's not to say that these companies can't turn it around and make big money for their investors. But for the most part, these are cross-your-fingers turnaround stories that have been relegated to the sub-$5 abyss for good reason.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway (the "B" shares mind you), but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.